Private Equity Fraud: How Firms Are Ripping Off Their Investors | New Republic

When liberals talk about economic regulation, they often use eye-rolling abstractions like “accountability” and “transparency.” What do those things even mean? How are those objectives enforced, and what would this enforcement even look like? Luckily we have a real-time example of what it all means, courtesy of Dodd-Frank and the SEC. It involves one of the more controversial parts of the financial markets, and it gives us a view into how reform happens.

As a result of the 2010 Dodd-Frank Wall Street Reform and Consumer Protection Act, private equity firms must register with the Securities and Exchange Commission (SEC). This, in turn, allows the SEC to examine the behavior of private equity firms on behalf of investors. The SEC just completed an initial wave of 150 firms, and what it found is shocking.

These results were unveiled last week when Andrew Bowden, the director of the SEC’s examinations office, gave a speech titled “Spreading Sunshine in Private Equity.” The big takeaway: Half of the SEC’s exams find corruption in the way fees and expenses are handled. Or as Bowden forcefully describes it: “When we have examined how fees and expenses are handled by advisers to private equity funds, we have identified what we believe are violations of law or material weaknesses in controls over 50 percent of the time.”

As Bowden notes, the business model of private equity, which manages almost $3.5 trillion dollars of our nation’s assets, has unique conflicts of interest built into the structure. Private equity firms use their client’s money to do leveraged buyouts of companies. Since this gives them major operating control of both the investment and a pool of other’s investment money, there are significant opportunities to shift costs and otherwise skim off their investors.

Bowden’s speech has numerous examples. One scam is to fire employees of the private equity firm and rehire them immediately as “consultants.” The investors are responsible for consultants’ salaries, where private equity employees are paid out of their own pockets. Another is taking what most private equity investors believe to be part of management fees, things like legal and compliance costs, and billing their investors for them without the investors properly knowing it. A third is private equity firms lying about the valuation methods they use to tell investors about the returns they make each year. All of these are ways for private equity firms to take money from their investors for themselves.

So what should people take away from this?

Unions, organizing, and playing the long game matter.

These revelations about private equity are directly the result of Dodd-Frank. And discussing with people familiar with how the bill progressed through Congress, there’s one big reason that this ended up in there: Unions fought for it. Especially the AFL-CIO, which fought to get this specific language into the bill. In 2007, the AFL-CIO issued a statement urging the SEC to be able to exam private equity firms this way. When financial reform came up for debate, they were able to make the case, and organizing groups pushing the agenda like Americans for Financial Reform also took up the cause.

In addition to having organizations fighting for transparency in financial markets, playing a long game matters. As Damon Silvers, Policy Director and Special Counsel for the AFL-CIO, told me, “certain policy ideas are kicked around for a very long time, and then there’s a window of opportunity. We fought for this for 15 years, and it’s a good lesson that you push for good ideas even when they don’t seem practical. Because when the window hits, you want to have solid ideas ready to go.”

Regulatory failures are a private sector phenomenon too.

At this point it’s fairly common to blame regulators for being “asleep at the wheel” in an era of deregulation and a hands-off approach to financial markets.

But not all regulators are public government ones. As the financial writer Yves Smith notes, private equity firms “can steal from their limited partners because the limited partners are asleep. The LPs have failed to negotiate for contractual protections when they have the most leverage, prior to investing, and they’ve been unwilling or unable to monitor their investments effectively once they’ve handed over their money.” In an era of privatization it’s important to note that private regulators meant to hold firms accountable can utterly fail. Public agencies with legal compulsion is a necessary part of a regulatory system.

Republicans are fighting this.

Many people argue that the Tea Party is against cronyism and the corrupt parts of the financial industry. Yet right now House Republicans are fighting to repeal the part of Dodd-Frank that allowed for this examination. Specifically they are putting a lot of energy into H.R. 1105, the ironically named Small Business Capital Access and Job Preservation Act, which would have prevented the SEC from finding this corruption.

94 percent of House Republicans voted for H.R. 1105 (218 votes), while only 18 percent of House Democrats (36 votes) did. It’s unlikely to go anywhere as President Obama has threatened to veto it.

To balance all the hot air about “corporatism” and “populism” on the right these days, watch things like H.R. 1105. I’m going to guess that no right-wing writers will flag this as a win for better financial markets. But this is how corporate power is actually checked in a marketplace, and the Tea Party and movement conservatism is against it.

Where financial reform lands is still in the air.

Dodd-Frank is many things, and one way to understand it is as a modernization of the regulatory framework put into place during the New Deal. Bringing private equity into the transparency and disclosure regime of the SEC is a necessary part of this effort.

Congress should still go further. As Heather Slavkin Corzo, a legal and policy expert at the AFL-CIO notes, there still isn’t regulation at the fund level. Congress can expand the SEC’s mission and require transparency and standardized disclosures of things like holdings, returns, and fee structures like we see in mutual funds. Also making this information public, which it isn’t under current Dodd-Frank rules, can allow investors to protect themselves better. This matters because, as Bowden describes, abuse here “adversely affects the retirement savings of teachers, firemen, police officers, and other workers across the U.S.”

And having corporate overlords who are comfortable looting both their businesses and investors isn’t good for the long-term prospects of the American economy. Democratic accountability is necessary to make this system work, and even a bit of transparency goes a very far way. The only question is whether we will build upon these insights or let them die on the vine.

Mike Konczal is a fellow with the Roosevelt Institute. Follow him on Twitter at @rortybomb.